Question

Today, the one-year U.S. interest rate is 2%, while the one-year interest rate in Mexico is 8%. The spot rate of the Mexico peso (MXP) is $.06 The one-year forward rate of the MXP exhibits a 10% discount. Determine the yield (percentage return on investment) to an investor from Mexico who engages in covered interest arbitrage.

Answer 1

Answer 2

To determine the yield (percentage return on investment) to an investor from Mexico who engages in covered interest arbitrage, we'll go through the steps of the arbitrage process.

1. Borrowing in the US: The investor borrows funds in the US at the one-year interest rate of 2%.

2. Converting to Mexican Peso (MXP): The investor converts the borrowed funds from US dollars to Mexican pesos at the spot rate of $0.06 per MXP.

3. Investing in Mexico: The investor invests the converted pesos in Mexico at the one-year interest rate of 8%.

4. Forward Contract: The investor enters into a one-year forward contract to sell the pesos and lock in the forward rate, which exhibits a 10% discount.

Now, let's calculate the yield from covered interest arbitrage:

Step 1: Borrowing in the US Assume the investor borrows $1 in the US.

Step 2: Converting to Mexican Peso (MXP) The spot rate of the MXP is $0.06. So, the investor will receive: 1 USD * 1 MXP / $0.06 = 16.67 MXP

Step 3: Investing in Mexico The investor invests the 16.67 MXP in Mexico at the one-year interest rate of 8%.

Interest earned in Mexico = 16.67 MXP * 8% = 1.334 MXP

Step 4: Forward Contract The forward rate exhibits a 10% discount, which means the investor can sell the 16.67 MXP at a forward rate of $0.06 * (1 - 0.10) = $0.054 per MXP.

Step 5: Conversion back to USD The investor converts the 16.67 MXP back to USD at the forward rate: 16.67 MXP * $0.054 / 1 MXP = $0.90

Step 6: Calculating the Yield (Percentage Return on Investment) The investor borrowed $1 in the US and received $0.90 after engaging in covered interest arbitrage.

Yield = (Final Amount - Initial Amount) / Initial Amount * 100 Yield = ($0.90 - $1) / $1 * 100 ≈ -10%

The yield from covered interest arbitrage is approximately -10%. This means that the investor will incur a negative return on investment of 10% due to the differences in interest rates and the forward rate discount.